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Tuesday, April 29, 2008

A Critique of Mainstream Monetary Economics

Mark Thoma points us to a speech by the iconoclastic Jamie Galbraith. In the speech Galbraith criticizes mainstream monetary economics or what he calls the "new monetary consensus."

...what in the “new monetary consensus,” led to a correct or even remotely relevant anticipation of the extraordinary financial crisis that broke over the housing sector, the banking system and the world economy in August 2007 and that has continued to preoccupy central bankers ever since? The answer is, of course, absolutely nothing.

Ouch! He continues his rant:

You will not find a word about financial crises, lender-of-last-resort functions or the nationalization of banks like Britain’s Northern Rock in papers dealing with monetary policy in the monetarist or the “new monetary consensus” traditions. What you will find, if you find anything at all, is a resolute, dogmatic, absolutist belief that monetary policy should not – should never – concern itself with such problems.

So what does Galbraith gives us as an alternative?

What is the relevant economics? Plainly, as many commentators have hastily rediscovered, it is the economics of John Maynard Keynes, of John Kenneth Galbraith and of Hyman Minsky...

I agree there is insight to be gleamed from these authors. However, the main policy prescription coming from these authors--more financial regulation is needed since financial systems tend to create their own crises--is general. How does one apply their insights in an dynamic world where financial innovations often are one step ahead of regulations? Also, how would these authors specifically implement monetary policy? Would they suggest a Taylor-like rule that had asset prices included in it?

For a more practical approach to monetary policy that takes seriously financial imbalances, I would suggest the work of Claudio Borio, Andrew Filardo, William White and others at the Bank for International Settlements. They have been thinking about these issue for some time and raised similar concerns prior to the outbreak of financial crisis in August 2007. Here is an excerpt of their work I discussed in a previous posting:

Economic historians will no doubt look back on the last twenty years of the 20th century as those that marked the end of a long inflationary phase in the world economy.... And yet, the same decades will in all probability also be remembered as those that saw the emergence of financial instability as a major policy concern, forcing its way to the top of the international agenda. One battlefront had opened up just as another was victoriously being closed. Ostensibly, lower inflation had not by itself yielded the hoped-for peace dividend of a more stable financial environment.

Is this confluence of events coincidental? What is the relationship between monetary and financial stability? What is an appropriate policy framework to secure both simultaneously?

[...]

We would like to make three points.

First, posing the question in terms of the desirability of a monetary response to "bubbles" per se is not the most helpful approach. Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions. Booms and busts in asset prices... are just one of a richer set of symptoms...

Second, while not disputing the fact that low and stable inflation promotes financial stability, we stress that financial imbalances can and do build up in periods of disinflation or in a low inflation environment. One reason is the common positive association between favourable supply-side developments, which put downward pressure on prices, on the one hand, and asset prices booms, easier access to external finance and optimistic assessments of risk, on the other

Third, achieving monetary and financial stability requires that appropriate anchors be put in place in both spheres. In a fiat standard, the only constraint in the monetary sphere on the expansion of credit and external finance is the policy rule of the monetary authorities. The process cannot be anchored unless the rule responds, directly or indirectly, to the build up of financial imbalances. In principle, safeguards in the financial sphere, in the form of prudential regulation and supervision, might be sufficient to prevent financial distress. In practice, however, they may be less than fully satisfactory...

What do you think about the international dimension? Arguably, one cause of the failure of the Fed policy in the last few years was the fact that China prevented their currency from appreciating, artificially giving US low inflation via cheap imports. As a result, the signal of lax monetary policy never got received.If it had, the FED would have raised rates earlier, potentially pre-empting the housing excesses. (This argument has been put forward by Axel Leijonhufvud, but like so much of his work, it just got no respect!)

JMK: I think an important development leading up to the present financial crisis is that many emerging economies, including China, kept their currency pegged to the dollar and thus imported the Fed's loose monetary policy in the early-to-mid 2000s. Because of this, even advance economies had to be mindful of the Fed policy lest their currencies became too expensive. They too, then, to some degree imported the Fed's loose monetary policy.

The Fed, then, was then the anchor for an expansionary international monetary system. See my related post on this topic here.